"In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value."
- Alan Greenspan
What is behind the value of the US dollar?
In the previous chapter, we saw how inflation is a monetary phenomenon. In particular, we noticed that inflation is often caused by the sudden increase in the money supply that doesn't meet an increase in production.
Now, the question should be: how can the government increase the money supply so fast? Isn't the currency backed by something? And finally, what is behind the value of the US dollar?
The reality is that nothing stops the government from increasing the money supply as they can print new dollars out of thin air. They can do it because the dollar is not backed by anything. The only thing that holds the value of the US dollar is "confidence."
I know it doesn't sound right. But the reality is that the US dollar is not backed by any real asset like gold or silver. The US dollar value is simply driven by supply and demand. If people lost confidence in the dollar, you would see the dollar's value plummet fast.
The problem with having the world reserve currency backed by confidence is that it may change quickly and without warning.
We would have to go back to 1944 to understand how the US dollar became the world reserve currency while being backed by confidence alone.
How the world lost the golden way and went FIAT:
Money wasn't always backed by confidence alone. Before 1944 most countries in the world followed the gold standard.
The gold standard meant that each country would guarantee to redeem its currency in exchange for a fixed amount of gold. This also meant that governments couldn't drastically increase the money supply without officially devaluing the currency against gold. Otherwise, there wouldn't be enough gold in the country's vaults to back all the paper currency circulating in the economy.
By backing a currency with gold reserves, people were confident to use the paper notes as a medium of exchange as they could always redeem their gold back.
This system ensured confidence, low inflation, and sound monetary policies from the government. Countries weren't able to finance crazy spending policies by simply printing money. The governments had reins that prevented them from going deeply into debt or overinflating their currencies.
In 1944 with the Bretton Woods Agreement, World War II allied nations agreed to peg their currencies to the US dollar and establish the US dollar as the world reserve currency. At the same time, the US dollar was pegged to gold at $35 for an ounce of gold.
With the Bretton Woods Agreement, the US dollar became the world reserve currency while guaranteeing convertibility to gold for $35 an ounce. It's important to understand that in 1944, allied nations would have never agreed to peg their currencies to a dollar not backed by gold.
After 1944, the US dollar demand increased rapidly, as most world currencies were convertible to US dollars at a fixed rate. This demand made the value of the US dollar rise and established the US as the dominant financial power of the world.
As history suggests, empires don't last forever. The US was the only country allowed to print US dollars, which they increasingly did to fund debt and deficits. These actions caused inflation as there was too much currency in circulation. The US government's first response was to devalue the dollar against gold. They brought the convertibility from $35 to $38 for an ounce of gold and then to $42 an ounce.
People panicked and started converting more and more dollars into gold as they saw the value decreasing rapidly. This run for gold concerned the US President as it could have drained the government from substantial reserves. On the 15th of August 1971, President Nixon officially interrupted all convertibility to gold, which meant that foreign nations couldn't convert their dollars into gold. This action signed the end of the Bretton Woods Agreement, the end of the gold standard for the world, and the beginning of the fiat era.
The dangers of fiat money:
"It is well enough that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."
- Henry Ford
According to the Oxford dictionary, fiat money is:
"Money that a government has declared to be legal tender, although it has no intrinsic value and is not backed by reserves."
It is crucial to understand fiat money to understand the world's inflation dynamics. By definition, fiat money is backed by nothing and derives its value solely from people's trust in it as a medium of exchange.
The main problem with fiat money is that governments can print unlimited amounts without any effort. This magic printer power allows governments to go deeply into debt as they can print the money necessary to repay it.
Without a gold standard, politicians have no reins or control. They can promise any social spending program and even fund wars without paying for it. Most government programs are funded by debt that will be paid through inflation. As William E. Simon said:
"American people have a love-hate relationship with inflation. They hate inflation but love everything that causes it."
If trust in a fiat currency goes away, there is nothing else than air supporting the currency's value. And as we are going to see in this chapter, it can happen faster than people think.
Past experiments of Fiat Money:
"Paper money eventually returns to its intrinsic value: zero."
The biggest flaw of fiat money is the absence of restraint or control over its supply. Human nature doesn't change much over time. It is sad to say it, but humans are greedy and insatiable by nature.
There has not been a fiat currency that stood the test of time. Many past experiments were able to last for decades, some more than a hundred years, but in the end, all fiat money returned to its intrinsic value: zero.
THE CHINESE EXPERIMENT:
The Chinese were the first to experiment with fiat money in the 10th century under the Song Dynasty. They issued paper money called jiaozi. Even though officially, the jiaozi was valued at a specific exchange rate for gold, silver, or silk, the government never allowed the conversion. Without any real backing, the jiaozi became the first fiat currency.
With time, the Chinese government printed more and more jiaozi to fund spending, creating inflation. The government tried to curb inflation with high taxes and other laws. However, confidence in the currency was lost, and the population disfavored the paper money.
The following Yuan dynasty attempted again to use paper currency. The Jiaochao was introduced and imposed as the medium of exchange. The scholar and explorer Ibn Battuta that lived in the 14th century, described the Chinese paper currency system as follows:
"The people of China do not do business for dinars and dirhams. In their country all the gold and silver they acquire they melt down into ingots, as we have said. They buy and sell with pieces of paper the size of the palm of the hand which are stamped with the Sultan's stamp. Twenty-five such pieces are called balisht, which is the same as dinar among us. If these pieces of paper become tattered from handling they take them to a house which is like our mint and receive new ones instead. The new pieces are not given against payment of any kind, for those in charge of this work receive regular salaries from the Sultan. The amir in charge of that house is one of the most important. If anyone goes to the bazaar with a silver dirham or a dinar intending to buy something with it, it is not accepted and he is disregarded until he pays with a balisht and buys what he wants."
As with the jiaozi of the Song dynasty, eventually, due to hyperinflation, the adoption of the Jiaochao was discontinued.
THE PLAYING CARD FAILURE:
Between 1685 and 1771, a new paper currency was born in the colony of New France (now part of Canada).
Since there was a shortage of french gold and silver coins in the colony, the government was forced to find a solution to pay its military after a failed campaign. Jacques de Meulles, the governor of New France, decided to use playing cards as paper money.
All playing cards were confiscated, cut into pieces, signed, and divided into different denominations. To build confidence in the new currency, the government assured the convertibility of playing cards into gold and silver.
With this newfound money, New France was able to pay its military and avoid dangerous consequences. What was initially meant to be a temporary expedient became the norm, and by 1757 the government had discontinued all payments in coins and used paper money instead.
The population lost confidence in the paper system as prices continued to go up, and in 1771 all playing cards were declared worthless and discontinued.
THE PAPER CURRENCY FORMULA
By studying history, we can see the same dynamics happen repeatedly:
The first step is to introduce a paper currency that is convertible into gold or silver. Like the French, the Chinese, and the US government did.
Once the population accepts the paper currency, the government starts printing more currency than it could back by its reserves. The government can then fund wars and promote social programs with the new paper money.
Once the supply of money grows too much, inflation begins, which often leads the government to stop the convertibility into gold and silver to avoid draining reserves. This move only worsens inflation, as the population loses confidence in the currency and runs to buy tangible assets. When trust is lost completely, the currency dies.
We have seen this process happening time after time in history. And unfortunately, we are doomed to repeat it as human nature doesn't change.
As the Irish writer George Bernard Shaw said:
"We learn from history that we learn nothing from history."