Friday, February 16, 2007

Weapons of Economic Warfare I (Money Supply Target)

What started out as a simple musing has become something much more. This may require some actual academic study and writing.

Now that I think I’ve identified most of the potential targets in an economic war, I can begin to discuss the “weapons’ that might be used to “neutralize” those targets. Having identified the weapons, defensive strategies can be developed. I’ll take the targets one at a time and identify some of the possible methods of neutralizing that specific target.

The first target is the monetary system. Without a well functioning monetary system a market economy is reduced to barter. This clearly limits the opportunities for specialization. It also increases the demand for foreign currencies to act as a hard currency, decreasing the cost to a foreign power of purchasing a specific resource or commodity. There are essentially two basic ways in which a monetary system can fail, general non-acceptance or hyper-inflation. One weapon with the potential for both impacts is counterfeiting. Countries have different laws governing responsibility for passing fake bills, so this may not have the same impact everywhere. For the sake of the argument, assume that once an individual has accepted a counterfeit bill, they are responsible for the loss. The greater expected loss due to counterfeit bills, the lower the likelihood an individual is to accept payment with that bill. It is now common to see many signs stating that denominations greater than $20 will not be accepted as payment. This is due, in large part, to the high number of counterfeit bills being passed. If this were to extend to include smaller denomination bills, a situation in which the currency falls out of acceptance may occur. Thus counterfeiting is a potential weapon of economic warfare. For this weapon to be effective, there are two key requirements. First, the attacking power must have the ability to create passable currency. In most modern economies a number of security features have been introduced to prevent or limit counterfeiting. Second, a method of injecting large quantities the counterfeit currency into circulation is required. The larger the monetary base under attack, the larger the required injection. For most modern economies, the required injection of counterfeit currency would be staggering. The likelihood of being able to inject such a quantity of currency without detection is small.

Many of the defenses against such an attack are already in place. Most currencies have built in security features. Currency unions increase the size of the counterfeiting operation required to have a strong negative impact. Virtually all economies have agencies charged with the responsibility of tracking down counterfeiters.

There is another method of attacking the monetary system of a country. This involves attacking the (electronic) records of the banking system. In a country using fractional reserve banking, a fictitious increase in a deposit will be multiplied through the banking system. In a banking system with a required reserve ratio of 10% an increase in deposits of $100 will lead to a $1000 increase in the money supply, with a reserve ratio of 1% the small deposit increases money supply be $10,000. Thus a relatively small number of falsified deposits can radically increase the supply of high powered money and thus cause inflation or even hyper-inflation. This multiplier effect is due to the increased loans made with the excess deposits. This attack could take place at one of number of sites. The records of the banks and near banks are an obvious target and many have taken steps to ensure the security of their record keeping. This security is far from perfect as the recent Winners/Home Sense security breach shows. The records of the central bank are also a possible target. Again these records tend to be defended against manipulation. There is some cause for concern about both of these sets of records. Generally, they are defended against manipulation for personal or corporate profit, rather than malicious attack.

Counterfeiting will have a similar impact on the supply of high powered money, though likely on a smaller scale due to monetary leakages and the fact that most monies first deposited at banks are checked against the passing of counterfeit bills.

Another vector for attacking a country’s monetary system is through international exchange markets. A number of countries have experienced currency crises or exchange rate attacks. An organized and well funded organization has the potential to initiate a run on most currencies. In such an attack, the value of the currency being attacked is greatly reduced relative to other currencies. This will have two impacts. First, it will make the cost of vital imports much higher for the victim. Countries which are extremely dependent on imports are particularly vulnerable to this type of weapon as the increase in input prices will lead to increased inflationary pressures. Japan comes to mind as a particularly susceptible. Second, by reduce the value of the domestic currency a campaign of asset acquisition by an unfriendly power will become much more feasible.
This attack will also serve to reduce the cost of exports from the country being attacked.

These weapons are designed to a limit a country’s ability to defend against unfriendly powers acquiring its assets or to resist a political. These weapons achieve this by destabilizing the monetary system of the economy. An economy with an unstable monetary system hardly able to coordinate the most basic of activities, let alone a defense.


OWEN said...
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ArtGirl said...

Just a side thought about using counterfeiting as a means of making a monetary system fail through non-acceptance. You said that the quantity of counterfeit money needed to cause this would be high. But if individuals have to take the loss for accepting a counterfeit bill, would it not be possible to use smaller quantities to target specific businesses or people instead of simply flooding an entire economic system with fakes? Their losses would then undermine confidence in the monetary system, creating a panic in the general populace. You would just need the right person to shout that the emperor was wearing no clothes, so to speak.
Let me know if I'm way off base here.

economistatlarge said...

Not off base at all. But it couldn't be just anybody and it would likely have to be more than one person. Say one shop owner decides they aren't going to take cash anymore, but everyone else was. End result would likely be the individual shop owner would lose a lot of business. If a bunch of people refuse to take cash, that's a different story.