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Fiat Money - Too Much of a "Good" Thing?

May 16, 2012, 5:24 PM

There is a good reason why the U.S. government prints the phrase “In God We Trust” on the currency. You have to have faith that the pieces of papers you carry in your wallet have value and that you can exchange goods and services for those bits of paper. Fiat money is not "backed up" by anything; intrinsically it is useless paper (nowadays not even that, but mere electronic bookkeeping entries). It is valuable only as far as people believe in its anticipated purchasing power.

When the US Federal Reserve said it would create another $600 billion to buy US Treasury debt, that made a total of $2.3 trillion added since the Fed began its QE program. In terms of simple math, Ben Bernanke has added three times as many dollars to America’s core money supply as all the previous treasury secretaries and Fed chairmen put together.

To create fiat money all you need is ink, paper and the printing press. Gold, on the other hand, requires gold mines, workers, expensive equipment and time. There will never be limitless, unending supplies of gold.

When money was made of precious metals, governments could debase it by reducing the quantity of metal in the coin. The introduction of paper money provided governments with a cheaper, easier, quicker method of debasing the value of the currency. From Roman times to the 17th century, when paper money in various forms begins to come into play, the history of coinage is a story of debasements, or the continuous reduction of the metallic content of the coins and a corresponding increase in all commodity prices.

History is replete with examples of the punishments meted out by governments to those who refused who accept government money. Thirteenth century Chinese law made the rejection of imperial paper money punishable by death. The penalty for refusing French notes was punishable by twenty years in prison. Early English law punished repudiation of currency as an offense against the dignity of a reigning sovereign. At the time of the American Revolution, non-acceptance of Continental notes was treated as an enemy act.

Government monopoly of money goes back to the dawn of history. The Greek philosopher Diogenes as early as the 4th century BC, is said to have called money the politicians' game of dice. Over the centuries, governments conducted various experiments with alternatives to gold. Paper was particularly promising since you could produce it cheaply and put as many zeros on it as you want. But inevitably, the experiments all ended badly.

Too much of a good thing is not so good. Too many dollars in circulation can cause inflation and the debasement of the dollar. This is even true when it comes to precious metals. The Spanish monarchy learned this lesson the hard way. After the discovery of silver in the New World, convoys of hundreds of ships transported tons of silver to the Spanish crown. The Spanish dug up so much silver, that the value of the metal itself declined in value causing inflation in the price of goods. All the silver of the Americas could not save Spain from economic decline.

The U.S. dollar has lost around 33% of its value in the past 10 years. This decline took place because the world is waking up to the awful realization that America has borrowed and spent its way into a hole.

How did the U.S. dollar become a reserve currency?

At the time that the Bretton Woods Agreement was signed towards the end of World War II, the U.S. was the mightiest economic and military power. And so it was decided that the other countries would use US dollars as their "reserves."

What does that mean?

The Bank of England, or the Bank of Germany, etc., used to issue their own domestic currencies, but maintain stockpiles of US dollars, with which they could regulate the value and fluctuations of their own currencies. (This was before the Euro supplanted national European currencies.) If the French Franc were to depreciate against the US dollar, for example, then the Bank of France could use some of its dollar holdings to buy francs, thus bringing up the value of the franc back to the required target. This way, investors and business people across the globe could feel comfortable with their French currency, because the franc was tied to the dollar and the dollar was tied to gold. Any central bank could redeem its dollars for gold from the U.S. at the fixed rate of $35 per ounce, that is, until Richard Nixon severed the dollar’s tie to gold in 1971.

Once the dollar was no longer tied by the peg to gold, the Federal Reserve began printing money, lately with reckless abandon.

So, it is not that surprising that none other than the President of the World Bank recommended that leading economies should consider readopting a modified global gold standard to guide currency movements. Robert Zoellick suggested some sort of role for gold in world currency as a successor to what he calls the "Bretton Woods II" system of floating currencies.

He gave the yellow metal the golden seal of approval by suggesting that the G20 should build a new system that would include a basket of currencies such as the dollar, the euro, the yen, the pound and the renminbi. The interesting part of what he said is as follows:

The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values. Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.

Zoellick is not exactly calling for currencies to be backed by hard assets again and what he is proposing seems vague, but it seems like this idea of using gold as a fixed reference point is a small step in that direction.

The press has seized on his gold comment with front-page banner headlines even though Zoellick mentioned gold almost in passing as his fifth and last proposal. But the world press has ignored those items focusing instead on his statement about gold.

What can we say? Gold is sexy.

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Shula Kopf
Sunshine Profits' Contributing Author

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