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Fiat currency is government-issued and government-backed legal tender which is not linked to the value of anything physical like gold, silver, or even copper.
Perhaps you’d like to call it: I-can’t-believe-it’s-actually-money, money.
If you read The Bible in Latin—I bet you don’t—on the first page in the third verse of Genesis, you run across the words “fiat lux,” meaning “let there be light.” Armed with this information you can deduce that the term “fiat currency” literally means “let there be currency.”
This widely-used term first saw the light of day in the book, “Fiat Money Inflation in France” published in 1875. It was an academic work written by Andrew Dickson White, the American historian, and co-founder of Cornell University.
At the time the book was written, there was a running debate about the nature of money. Andrew White chose the words “fiat currency” to describe money which has no intrinsic value. If you’ve never studied the subject, you’ll be surprised by how many different things that have value of themselves have been used as money at various times. Of course, it’s true of gold and silver coins, but it’s also true of beaver pelts (used as currency in New France, now part of Canada) and cigarettes (used as currency for over two years in post-WW2 Germany).
Surprisingly, cowry shells proved popular for many centuries. They were used as currency in ancient China, so much so that Classical Chinese character for “money/currency”, 貝, is believed to be a pictograph of a cowrie shell. And because cowries occur near the shores of almost all countries that border the Indian ocean, they were used as money in India and African countries that border that ocean.
The Birth of Paper Money
So, something qualifies as real money if it has “intrinsic” value—beaver pelts, cigarettes, and cowries were regarded as valuable by the peoples who accepted them as money, just as gold and silver were.
The Chinese invented paper money, some time in the Tang Dynasty (618-907 AD), and used engraved wooden blocks to print it. They gradually became increasingly sophisticated in financial activities, developing credit mechanisms—merchants began to use promissory notes (credit notes) for long-distance trade. During the Song Dynasty (960-1276) merchants were invited to deposit their coins with the Government Treasury in exchange for “flying money” (Fey-thsian).
Curiously, the motivation for flying money wasn’t a desire to inflate the money supply. It was done because China was running out of coins. This is a money-supply problem we rarely hear of now, but it often plagued coin-based economies. Some merchants issued private drafts (banknotes in effect) that were backed by coins and salt, and later on by gold and silver. In 1024, the government took sole control of issuing these notes.
Then, during the Yuan Dynasty (1279-1367), paper money was declared to be the only legal tender. The paper money experiment began to go badly wrong during the Ming Dynasty (1368-1644). New notes were introduced into circulation without withdrawing older notes. Monetary inflation followed, as naturally as night follows day. In 1380, one Chinese guan was worth 1000 copper coins, by 1535, its value had reduced to 0.28 copper coins.
What Is Inflation?
It is worth pointing out here that the word “inflation” in a financial context is often misunderstood by people to mean “rising prices.” That is not its meaning. It means precisely “an increase in the supply of money.” Rising prices are a possible, but not guaranteed, result of inflating the money supply.
If you increase the supply of money, but that new money ends up with people who choose never to spend it, it will not cause prices to rise. Prices will rise only if the money circulates. And prices can rise for other reasons—a poor harvest will raise the price of grain without any help from an inflated money supply.
A Tale of Two Cities
Europe lagged China by centuries in the use of paper money, which didn’t get going until the printing press had been invented. The idea was tried in Sweden in 1661 by Stockholm’s Banco, linking banknotes directly to deposits of coins. The bank then foolishly printed more notes than there were deposits. It went bankrupt after three years. At about the same time, the goldsmith-bankers in London began creating notes linked to deposits, but they were conservative in issuing them. These proved to be a prototype for a national currency.
In 1694 the English government established the Bank of England, printing notes that guaranteed access to an amount of silver. But it wasn’t until 1745 that it issued fixed denomination notes from £20 to £1,000—the first true British banknotes.
While London moved slowly, Paris moved quickly, under the influence of the Scottish economist, John Law. He was an original economic thinker and a historically influential one. He invented the scarcity theory of value—a model for the interaction between supply and demand. He wrote the Real Bills Doctrine, which considers the required relationship between bank assets and liabilities and which set the foundation for modern banking. He believed that monetary inflation would stimulate an economy—and it does in the short term. But that opinion led to his downfall.
Law was also a successful gambler with a good understanding of probability. It was his gambling skills that brought him to the attention of the French aristocracy and his economic ideas that persuaded the Duke of Orleans to appoint him as Controller General of Finances of France.
When John Law took charge, France was in a financial mess. Louis XIV’s War of the Spanish Succession had left France in economic distress. The economy was stagnant and the national debt was crippling. A shortage of precious metals caused a shortage of coins in circulation.
Law’s solution was to replace gold with paper credit and then gradually increase the supply of credit. He believed this would stimulate commerce, and thus help to reduce the national debt. He intended to replace the national debt with shares in prosperous economic ventures.
To cut a long story short, Law issued bank notes based on gold coins combined in a 1 to 3 ratio with defunct government bonds, inflating the currency by a factor of 3 from the get-go. He then provoked a speculative bubble by founding the Mississippi Company, a monopoly trading company. The company’s stock rose by 60 times its initial value and then collapsed causing French citizens to dump their paper money for coins. When that happened, he was shown the door.
Real Paper Money: The Gold Standard
By the nineteenth century, the phenomenon of paper money inflation was better understood. John Law’s disastrous French experiment proved to be an object lesson and a highly effective deterrent. The faith in coinage (gold and silver) was even enshrined in the US constitution, where Article 1, Section 10 states:
“[No State shall] make any Thing but gold and silver Coin a Tender in Payment of Debts;”
From 1837 to 1863, a period of 26 years, the US had no central banks, just heavily regulated state-chartered banks that issued banknotes against specie (precious-metal-based coinage). Then, with the National Banking Act of 1863, a system of national banks was established with the intent of creating a uniform national currency and paying for the Union’s civil war costs.
Wars are costly. The US issued “Greenback” dollars that were not backed by precious metals to pay for it. But in a series of legislative changes, which began in 1873, the US gradually moved to a gold standard with all bank notes backed by gold.
The British had been operating a gold standard since 1844, and much of the British Empire naturally fell in line. In 1873, Germany adopted the gold standard and France followed suit. Throughout the 19th-century, banknotes backed by gold gradually superseded gold and silver coinage.
A gold standard emerged. It prevented undisciplined and inflationary money-printing and it reduced the need for coins. It also enforced a fixed exchange rate between currencies, facilitating global trade. Because currency was exchangeable for gold, gold naturally migrated to the more successful economies, increasing the money supply in accordance with the national balance of trade.
What’s not to love?
Gold does not provide a perfect basis for a commodity-backed currency, but, historically, it has proved to be the best choice. Currently, the world’s above-ground gold stock grows by 1 to 2% annually. About half the gold in existence is used for jewelry, about 20% is owned by central banks, a further 20% by private investors, and the remainder is employed industrially. The neat thing about gold is that it isn’t destroyed by usage; almost all industrially used gold is recovered and recycled.
The glitches in gold-based currencies happen with discoveries of significant new deposits. But this is rare. It happened when Spain raided the Aztecs and the Incas for gold, and as a result of the California gold rush of 1849, the Australian gold rush of 1851, and the Witwatersrand gold rush of 1886. It would require a truly dramatic new gold find to increase the existing stock of gold significantly.
There are currently about 190,000 tonnes of mined gold, with an estimated 54,000 tonnes still below ground. Most of those 190,000 tonnes are more recent than you might imagine. Two-thirds of it has been mined since 1950.
The Rocky Road to Fiat Currency
The question is: why did the gold standard fail?
But it’s the wrong question. The gold standard didn’t fail; it worked. The intention with the gold standard was to prevent the debasement of paper currency by making it exchangeable with something that couldn’t be debased: gold. All the evidence suggests that it works, even allowing for the disruption imposed by the occasional major gold discovery.
Paper money that is linked directly to gold—something that cannot be inflated by fiat, is not fiat money. Paper money becomes fiat money when the link between the paper and the gold is cut.
In the first decade of the twentieth century, the major economies of the world had moved their currencies to implement a gold standard. Then came the wars – without money, you cannot fight them. And the easiest way to pay for them is in fiat money because you can print it without it becoming immediately obvious to your citizens. The economists could not object—losing the war will be far worse economically than a dose of inflation.
After World War I, only the US truly remained on the gold standard. Other countries tried to go back to it, but the Great Depression foiled that.
In 1934, the US Congress passed the Gold Reserve Act, which nationalized all gold by ordering Federal Reserve banks to turn over their physical gold to the U.S. Treasury. In return, the banks received gold certificates to be used as reserves against deposits and Federal Reserve notes. The act authorized the president to devalue the gold-linked dollar, which he quickly did. This bumped the gold value of the dollar from $20.67 to $35 per ounce, a devaluation of over 40%.
The effect was to allow the Federal Reserve to print money in the hope of combatting rampant deflation. That’s right, deflation rather than inflation!!
The Force of Deflation
The money supply can expand as well as contract. If paper money is printed and it circulates, then in general prices will rise. However, when an economy goes into recession or a depression, many people and businesses are no longer able to pay their debts. An unpaid debt is money that disappears. The usual way to combat such a contraction of the money supply is to print money and make it available to the banks so that they remain solvent.
This is the other side of the coin, as regards fiat money. Not only does fiat money make inflation possible, it also makes deflation possible. Neither of those is good for the health of an economy.
At the end of World War II, another very expensive war, which only the US survived with its economy intact, a new international standard for currencies was implemented, that went by the name of Bretton Woods.
The idea was that countries would fix their exchange rate against the US dollar and would be able to exchange their dollar holdings for gold at the official exchange rate of $35 per ounce whenever they so wished. Neither businesses nor individuals were allowed to do that, so convertibility was highly constrained. Depriving individuals of owning gold (except for jewelry) removed a great deal of liquidity from the market and thus helped to stabilize the dollar price of gold.
So the US dollar then became the world’s primary reserve currency—the currency that countries and large businesses needed to hold to conduct international trade. They held dollars for the same reason that people and companies once held gold coins: as a common currency. The dollar was suitable because of its link to gold, and all countries could swap their dollar holdings for gold whenever they wished.
This worked very well until it didn’t.
Starting in 1959 and continuing for over a decade, France decided to continuously exchange its dollar reserves for gold at the official rate. In the latter part of the 1960s, the US was spending heavily on the Vietnam War and was running a persistent balance of payments deficit. Eventually, the US was obliged to cut the deficits or cut the link to gold.
President Nixon chose the latter—on August 15, 1971, the US abandoned the convertibility of the US dollar to gold.
And Then There Was Fiat
It is a remarkable fact that for the last 50 years no currencies in the world have had any intrinsic value. They are nothing more than paper, no matter which country you live in. And few people care.
The only thing that is backing the US dollar is faith that the US government will support it and maintain the current system of currency exchange across the markets of the world. However, this system favors the US. It remains to be seen whether the dominance of the dollar will be challenged.
What Could Challenge It?
Why, cryptocurrencies, of course. Currencies that can be designed to be proof against the twin systemic threats of inflation and deflation.