Money Creation, Crisis Edition - Save, Wait, Recreate

Analysis by Gaelle Nohra, Contributor

August 23rd, 2021

The term “money creation” primarily belongs to the banking sector where banks create money by lending money at an interest rate higher than the cost at which they initially borrowed. The process is thus made possible by the availability of excess reserves, which are capital reserves more than what is required. This article won’t tackle course of money creation in banks, but rather shed light upon an informal money creation scheme lying within the soaring USD-LBP exchange rate ever since October 2019. Moreover, this article will attempt to draw the usefulness of this scheme.

Being detached from all the complex formalities of lending/borrowing and not requiring any understanding of banks’ balance sheets, the creation process is illustrated by observing three separate moments on the timeline of the Lebanese economic crisis. For simplicity purposes, let us refer to each of these three times as T1, T2, and T3. At T1, one United States Dollar (USD) accounts for one and a half thousand Lebanese Pounds (LBP). This time obviously refers to the 1997-2019 phase denoting the period through which the LBP was pegged to the U.S.D.  As for T2 and T3, they capture two different moments during which the USD-LBP exchange rate was (and still is) on its rise. For instance, let us consider that one USD accounts for four LBP at T2 (May 2020), and fourteen LBP at T3 (June 2021). [i]

Consider the following scenario: when one Lebanese trader is fully convinced about the impossibility of recovery anytime soon and starts anticipating an ongoing instability for the exchange rate, he immediately converted his entire LBP wealth into USD, regardless of its worthlessness. Suppose this happened in May 2020 (T2 moment), the trader possessed 30 LBP which yielded 30/4= 7.5 USDs (choosing small numbers for simplicity purposes). Suppose he kept this amount intact up until June 2021 (T3 moment). Upon reconversion to LBP in June 2021, the 7.5 USD yielded 7.5*14 = 105 LBP. By this process, the trader could make an additional sum of 75 LBP in pure LBP amount.

Therefore, with political instability prevailing and the value of the dollar unceasingly rising, there is always room to compensate for the loss resulting from the deterioration of the exchange rate. What renders the term “always” relevant is first the self-imposing reality of the soaring demand for the dollar, for it is known that the higher demand there is for a currency[ii], the higher goes its value. Second, political instability accompanied by a detrimental confidence loss in the power of the local currency are capable of further expanding the lifespan of the dollar’s escalation journey, thus keeping this money creation an open-ended game.

And there it goes: new LBP money can always be created as long as the USD’s price knows no roof and as long as money holders are patient enough to save, wait for a satisfying rise of the rate, and recreate new wealth. In fact, this scheme could be partially beneficial when no single exchange rate is being imposed. As implied by Nizar Ghanem, Lebanese analyst on economic policy, “The Central Bank is deliberately letting trade happen at multiple exchange rates”. [iii]While some traders are adapting the most recent (i.e, black-market dictated) exchange rates when pricing their products, others prefer sticking to lower rates in the fear of losing their customers.

Now that compensation is almost certain, it remains doubtlessly crucial to address the multifarious inconveniences rendering it pointless. First, the 7.5 USD were kept intact and not at the trader’s disposal in case he needed liquidity, the amount’s function as a medium of exchange has thus been taken down. Second, the time element. To generate these 75 LBPs you need to have the luxury of time and wait for at least a year. What’s worse is that in parallel to this creation takes place an unbeatable inflation dragging a daily downgrade of the LBP’s purchasing power. Hence, the presence of these two reasons is enough to deem this money creation as pointless and unrewarding. The occasional condition under which gains could be preserved happens when the rate at which the USD-LBP exchange rate is increasing is relatively lower than rate at which new LBP money is generated from the exercise of converting and reconverting.

All amidst economic chaos, positive externalities can always be drawn, and this example is no exception. However, even these externalities are barely at the disposal of the underprivileged, especially when even saving, essential step of this money creation type, has become a luxury in Lebanon.

[i] Lebanese Lira Today. Retrieved from https://lirarate.org/

[ii] Supply and Demand in Currency Markets. Retrieved from https://www.forbes.com/2006/08/23/forex-trading-education-in_swh_0823investools_inl.html?sh=bf5b0c56cfd0

[iii] Nobody Knows What Lebanon’s Currency is Worth Anymore. Retrieved from https://foreignpolicy.com/2021/04/05/lebanon-currency-inflation-exchange-rates/