Why Does Fiat Money Seemingly Work?

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Submitted by Pater Tenebrarum via Acting-Man blog,

Introducing Money

Imagine three men living on a small island. Toni is mining the local salt mine, and apart from him there are Pete the fisherman and Tom the apple grower and their families. They have a barter trading system set up: Toni exchanges his salt for Pete’s fishes and Tom’s apples, who in turn exchange fishes and apples between each other.

One day Pete says: “I have an idea. Instead of fish, I will from now on give you pieces of papyrus with numbers marked on them”. Papyrus grows in great quantities nearby, but has so far not been of practical use to any of the islanders. Pete continues: “One papyrus mark will represent 1 fish or 5 apples or 2 bags of salt (equivalent to current barter exchange rates). This will make it easier for us to trade among ourselves. We won’t have to lug fishes, apples and salt around all the time. Instead, we can simply present the pieces of papyrus to each other for exchange on demand.”

 

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John Law at a young age – the world’s first Keynesian economist

Painting by Casimir Balthazar

In short, Pete wants to modernize their little island economy by introducing money – and he already has one of those new papyrus notes with him, which he is eager to trade for salt. However, the others would immediately realize that there is a problem: the papyrus per se is not of any value, since none of them have found a use for it as yet. If they were all to agree on using the papyrus as a medium of exchange, its value would rest on a promise alone – Pete’s promise that any papyrus he issues will actually be “backed” by fish, which would make Toni and Tom willing to accept it in exchange for salt and apples.

Since papyrus grows in great abundance on the island, Pete could easily issue money by the bucket load. Both Toni and Tom like Pete, but they can see that the idea of installing him as the island’s papyrus banker would likely tempt him into taking advantage of them. In fact, it is unlikely that any of the islanders would ever propose such an idea.

It is far more likely that they would use another good as a medium for indirect exchange, one for which there is an actual demand (for instance, a rare type of sea-shell that is prized as an ornament and only seldom found on the island). In short, in a free market, only be something that enjoys an already established demand due to its use value would emerge as a medium of exchange. An object widely considered as worthless would never become money in a free market.

However, today, we all use irredeemable paper money. How did essentially worthless objects come to be widely accepted as money? Let us take a brief detour and look at a few slices of monetary history.

 

Flashback: Rome 27 BC – AD 301

Rome’s long history of inflation and monetary debasement actually started with Cesar’s successor Augustus, whereby his method was at least not a prima facie fraud. He simply ordered the mines to overproduce silver so as to finance the empire that had grown greatly in size under Cesar and himself. When this overproduction began to have inflationary effects, Augustus wisely decided to cut back on the issuance of coins. This was the last time that a Roman emperor attempted to correct a monetary policy blunder by honest means, aside from a brief flashing up of monetary rectitude under Emperor Aurelius some 280 years later.

Under Augustus’ successors, the situation deteriorated at a rapid clip. Claudius, Caligula and Nero all embarked on enormous spending sprees that depleted Rome’s treasury. It was Nero who first came up with the idea to actually debase coins by reducing their silver content in AD 64 , and things quickly went downhill from there.

It should be mentioned that Mark Anthony financed the army he used in his fight against Octavian – the later Augustus – with debased coinage as well. These coins remained in circulation for a long time, in line with Gresham’s Law – “bad money drives good money from circulation”.

 

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An AD 275 specimen of Aurelian’s bronze Antoninianus, 1 part silver to 20 parts copper.

In AD 274 the soldier-emperor Aurelius (who ruled from AD 270-AD 275) entered the scene with a well-intentioned monetary reform, by fixing the silver-copper content of the then most widely used coin, the Antoninianus, at a 1:20 ratio. However, shortly after this reform was instituted, the coin’s silver content resumed its inexorable decline.

 

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Emperor Diocletian, the price fixer

Photo via Wikimedia Commons

In AD 301 Emperor Diocletian tried his hand at reform, this time by instituting price controls to mask the effects of his inflationary policies, a policy repeated by numerous politicians many times thereafter, in spite of the fact that it can be shown both theoretically and empirically that it never works (Richard Nixon’s ill-fated experiment with price controls serves as a fairly recent example, as well as similar policies currently enacted in Venezuela).

Diocletian’s price control edict de pretiis rerum venalium (which he soon repealed again, as it proved unenforceable in spite of harsh punishments meted out to people trying to circumvent it) accelerated Rome’s downfall, as goods simply began to disappear from the marketplace. Merchants would rather hide their goods than accept an edict forcing them to sell them at a loss. Shortages of goods are an inevitable effect of price controls.

It is no exaggeration to state that monetary inflation combined with subsidies and attempts to centrally control important aspects of the economy eventually caused Rome’s downfall. The ancient Romans at least had the excuse that they were not familiar with economic and monetary theory. As this brief look at slices of Rome’s monetary history shows, governments have engaged in theft from the citizenry via monetary debasement from the very dawn of Western civilization.

 

Money Substitutes Enter the Scene

How was the leap from debasing coinage to outright fiat money accomplished?There are two distinct intertwined historical developments that ultimately led to the present system. Fractional reserve banking was first practiced by the forerunners of modern day commercial banks, namely the goldsmiths.

 

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A goldsmith deposit receipt from 1729

Photo via britishmuseum.org

Goldsmiths were used as depositories for gold and silver, and the receipts they issued for such deposits soon began to circulate as the first bank notes – especially once they hit upon the idea of issuing “bearer” receipts instead of tying receipts to specific deposits. This has obvious advantages, and since one gold coin is as good as any other of the same weight and fineness, there is obviously no need for the strict allocation of deposits.

The convenience of carrying and using these banknotes instead of lugging around bags of gold and silver soon made them popular, and it didn’t take long for the goldsmiths to realize that the actual coin deposits were rarely withdrawn in great quantities. Instead, the receipts would remain in circulation, being regarded as perfect money substitutes. It followed from this that one could temporarily lend deposits out and collect interest on such loans. This was problematic from a legal perspective, as demand deposits should be available at all times.

Moreover, since the originally issued receipts remained in circulation, the total money supply actually increased once these deposits were lent out. In fact, many goldsmiths simply issued additional receipts for gold, even if they were not actually backed by deposits (with a similar effect on the broadly defined money supply). This was an early form of fractional reserve banking, namely lending out far more receipts for money than one actually holds in one’s vaults. Obviously, this activity was fraudulent (some people claim it was merely “ingenious”). Nevertheless, it is perfectly legal today, although it remains in essence the same fraud it has always been. The main difference is that today it is a far more sophisticated, as well as officially sanctioned fraud.

When bank notes were still backed (at least partially) by specie on deposit, the expansion of money substitutes was frequently held in check by bank runs (or from a banker’s perspective, the fear of bank runs). Nowadays, no such fear exists. The lender of last resort – the central bank – can (up to a point) prevent bank runs by conjuring new money out of thin air and making it available to banks in distress.

 

Tally Sticks and Charles II

The other historical development that can be seen as an important ancestor of the modern day fiat money system is England’s application of the medieval tally stick system of recording payments. Taxes in the largely agricultural economy of the Middle Ages were usually paid in the form of goods, and these payments were recorded with notches on wooden sticks that were then split in half length-wise (one half remained with the tax paying serf, as proof of payment). This was an ingenious method of preventing counterfeiting of receipts, as the two halves of a tally stick perfectly match and every tally stick is unique.

In AD 1100, King Henry the First ascended the English throne and adopted the tally stick method for the purpose of recording tax payments. By the time of Henry II’s reign, taxes were paid twice a year, and a secondary market for tally sticks recording the partial tax payment made at Easter developed. Tally sticks were circulating in the secondary market at a discount to their face value and were accepted as payment for goods and services, since they could be later presented to the exchequer as proof of taxes paid.

It didn’t take long for the king and his treasurer to realize that they could actually issue tally sticks in advance, in order to finance “emergency spending” (such emergencies often involved war). The sale of these claims to future tax revenue created the market for government debt – which is an essential part of today’s fiat money system as well.

 

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A wooden stick for recording transactions. Made in England in the third quarter of the thirteenth century, the first stick reads “£9.4s.4d. from Fulk Basset for the farm of Wycombe“; probably Fulco Basset, bishop of London, who died of the plague in 1259. The second one reads: “£4. 8p. from Robert of Curclington for an injustice.

After a brief hiatus of experimentation with a pseudo-republican government under Oliver Cromwell, the English monarchy was reinstated in 1660 and Charles II began his reign, albeit with vastly reduced powers, especially in the realm of taxation. Since Charles had to beg the parliament for money, he struggled mightily with paying his vast pile of bills. Whenever Charles wrangled permission to raise taxes from parliament, he immediately went to cash in these future tax receipts by selling tally sticks to London’s goldsmiths at a discount. Such debt was payable to the bearer, which allowed the goldsmiths to sell it in the secondary market to raise yet more funds that could be lent to the king.

They also began to pay interest to depositors, in order to attract still more funds. At that stage of the game, the goldsmiths figured they had a good thing going for them, since the king was widely regarded as the equivalent of a modern-day triple A rated sovereign borrower, who could always be relied upon to cover his debts with future tax receipts. No one thought it problematic that the vaults soon contained far more wooden sticks than gold. An active market in this government debt developed, and the goldsmiths profited handsomely.

The king meanwhile decided on a cunning plan: he decided to circumvent parliament and began to issue tally sticks as he pleased (as an aside, one half of such a stick, which was given to the party advancing funds, had a handle and was called the “stock”, while the other half was called the “foil”. The term “stock” has evolved to describe shares in publicly listed corporations today). Not surprisingly, Charles was more than happy to exchange sticks of wood for gold and soon kicked off a sizable credit boom by vastly increasing his production of wooden sticks.

 

(c) Mount Edgcumbe House; Supplied by The Public Catalogue Foundation

Charles II, the “Merry Monarch”, in all his splendor, his eyes firmly focused on the loot.

Painting by Peter Lely

So what did the king do with all the gold he received for his tally sticks? During his 25 year reign, he waged three wars, all of which he lost (two against the Dutch, one against France); he survived 4 different parliaments (only the first of which wasn’t hostile to him); he helped to establish the East India Company, made numerous shady deals with Louis XIV of France (his cousin), sired a horde of illegitimate children of which he acknowledged 14, and was renowned all over the show for his hedonistic court. That, along with the king’s ability to talk London’s goldsmiths into handing over their gold for wooden sticks may explain why Charles was nicknamed the “Merry Monarch”.

 

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Contents of the typical London goldsmith safe at the height of the king’s borrowing spree.

Photo credit: The National Archives, Kew

There was of course a natural limit to this debt expansion. Once all the money attracted from depositors had been transferred to the king, additional deposits could only be acquired by means of offering higher interest rates than previously. By 1671 the annual discount on the King’s debt had reached 10%. As redemption demands nearly overwhelmed the funds raised by new debt issues, the king’s cunning plan had clearly ceased to work. However, Charles suddenly and quite conveniently remembered that there was a law against usury on the statute books, and lo and behold, interest rates in excess of 6% were actually not permissible.

Since all his recently issued debt carried a far bigger discount, he simply declared the debt illegal, and stopped making payments on it (with a few judiciously selected exceptions, i.e., it was a selective default). Overnight, the king’s tally sticks reverted back to what they had really always been – worthless sticks of wood. The king’s creditors, chiefly the goldsmiths and their customers, had quite literally “drawn the short end of the stick” (if you have ever wondered where this expression comes from, this is it).

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Charles II as he is apparently remembered today – a knight in shining armor, not the warmongering thief that he actually was.

Photo credit: Julian Deghy

Although tally sticks were still used until the early 19th century, and even formed part of the capital of the Bank of England when it was founded in 1694, the secondary market never really recovered from this blow. With the stroke of a pen, Charles had killed off the better part of London’s budding banking system, and transformed countless of his creditors into destitute and quite involuntary donors to the crown.

To add insult to injury, he even gained a propaganda victory, as the public blamed the goldsmiths for the ensuing mess. They were of course not entirely innocent, above all they had proved quite gullible (a bit like the people buying government bonds with negative yields today…). Eventually, all the still extant tally sticks were burned in the coal furnaces under the House of Lords in 1834 – and by mistake, the entire Palace of Westminster burned down with them.

 

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J.M.W. Turner’s painting “The Burning of the Houses of Lords and Commons” in 1834. Turner had witnessed the event first hand.

What the tally stick system did however achieve, was to plant the idea of how a fiat money system might actually be made to work. The tally stick system and the transformation of goldsmiths from deposit taking institutions into bankers practicing fractional reserve banking delivered the basics of the structure of the modern monetary system.

 

John Law’s Fiat Money Experiment in France

It was a Scotsman – John Law – ironically born in the very year (1671) when Charles II defaulted on his debt, who tried the first great fiat money experiment inspired by these ideas. Living in exile in France, he found a willing partner in Philippe II, the Duc d’Orléans, who was the regent of a near bankrupt state and proved eager to put John Law’s ideas into practice.

 

duc d'orleans-3

Philippe II, the duc d’Orléans. When Louis XIV of France died in 1715, Philippe d’Orléans became Regent to the then five-year-old King. Together with John Law, he proceeded to completely wreck France’s economy.

Copper engraving, 1750, via ancestryimages.com

John Law’s basic idea was that the more money was in circulation, the greater the prosperity of a country would be. He discussed these ideas in a treatise published in 1705, entitled Money and Trade Considered.

In Law’s own words:

Domestic trade depends upon money. A greater quantity [of money] employs more people than a lesser quantity. An addition to the money adds to the value of the country.”

Considering the above quote, John Law was arguably the world’s first Keynesian economist. He evidently thought that economic growth was the result of “spending”. John Law became France’s comptroller general of finances and set up the Banque Générale Privée (later renamed the Banque Royale), which used French government debt as the bulk of its reserves and began to emit paper money ostensibly “backed” by this debt – however, with a promise attached that the notes could be converted to gold coin on demand. There was actually neither an ability nor a willingness to keep this promise.

In an effort to make the new paper money more palatable to a distrustful public, it was decided to make it acceptable for payment of taxes (this idea is key and and as noted above was the reason why English tally sticks were able to function as a secondary medium of exchange). A credit and asset boom of vast proportions ensued, and became especially pronounced after Law decided to float shares of the Compagnie des Indes, a.k.a. the Mississippi Company, which enjoyed a trade monopoly with the New World and the West Indies.

Between 1719 and 1720 shares in the company rose from 500 to 10,000 livres. Predictably, the bubble eventually burst, and the stock lost 97% of its peak value in the subsequent bust. Enraged and nervous financiers tried to convert their Banque Royale banknotes into specie in the ensuing economic crisis, but naturally, the central bank’s promise of convertibility could not be fulfilled – it had inflated the supply of bank notes way too much (in the end, its notes traded at discounts of up to 99% of their face value).

The government at first tried to stem the tide with edicts forbidding the private ownership of gold, but the enraged population eventually drove Law into exile, and the fiat money experiment ended with the Banque Royale closing its doors forever, leaving France in a far worse economic position than before the experiment. Countless “paper millionaires” had become destitute paupers.

 

Mississipi Panic

1720: Investors in John Law’s Mississippi Company scam are desperate to get their money back

Copper engraving by Antoine Humblot

 

The economic crisis following the collapse of Law’s Mississippi enterprise and fiat money scheme gripped all of Europe – the eloquent master of fiat disaster had seduced investors from all over the continent, many of whom suddenly found themselves penniless. Confidence in other European banks and companies eroded as well, and a great many bankruptcies ensued. Still, Law’s idea, evidently copied from the tally stick system, that fiat money could be supported by making it the medium in which tax obligations could be discharged was not forgotten.

 

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Share price of John Law’s “Compagnie des Indes” – eventually, the stock made a complete round-trip.

 

There are several historical examples similar to to the above, such as e.g. the fiat money inflation in France under the revolutionary assembly, which took place a scant 70 years after John Law had ruined the country and ruined it all over again. Numerous hyper-inflation episodes have taken place in the course of the 20th century as well, always in connection with attempts to fund government spending with the printing press.

 

From Coin Clipping to Fiat Money

For a long time, States were forced to accept gold’s role as money. The introduction of irredeemable paper money wasn’t considered viable, and failed experiments such as John Law’s served to dissuade governments from pursuing the idea further. Rather, heads of State resorted to coin clipping or otherwise diluting the precious metals content of coins if they wished to rob the citizenry via inflation. These early instances of inflation by means of reducing the precious metals content of coins led to the downfall of entire empires, with the Roman empire the most prominent. However, the tally stick system and John Law already demonstrated how public demand for fiat currency could be generated, namely by means of government accepting it for payment of taxes.

This is why pieces of paper with some ink slapped on them are not laughed out of the room straight away. The two major pillars of this system are based on coercion: directly via the legal tender laws, which decree that fiat currency must be used in and accepted for all payments of debt, public or private, and indirectly via the demand for fiat money as a means to discharge tax obligations. It is safe to say that without this second criterion, it would have been impossible for governments to “monetize” irredeemable paper.

The mere legal proclamation that something shall be money does not suffice to make it money in the economic sense, just as the “official demonetization” of a market-chosen money commodity cannot rob it entirely of its monetary characteristics. It is necessary that market participants use whatever object has been declared to be legal money in commercial transactions. If they are doing so, then it is money.

As noted above, banknotes were originally merely money substitutes – claims to definite weights of metallic money held in bank vaults. People were getting used to these money substitutes representing money, and governments instituted the changeover to fiat money by robbing these money substitutes of their convertibility, gambling that people would continue to use them in commercial transaction anyway, out of habit. Nowadays banknotes are no longer money substitutes, but have effectively become standard money. Money substitutes consist of the two kinds of deposit money: uncovered (fiduciary media for which no counterpart in the form of standard money exists) and covered money substitutes (deposit money for which bank reserves exist, either in the form of vault cash or as reserves held at the central bank).

What is also extremely important for the system to function is faith in the value of government debt, which rests on the conviction that governments will be able to extract enough wealth from their citizens in the future to repay it. Government bonds so to speak serve as the main “backing” of bank notes and their digital counterparts in circulation. They are tying governments and the banking system together via the central bank. The central bank has the power to “monetize” such debt by creating new money out of thin air and using it to buy debt securities. This roundabout way of going about money creation is an essential part of the confidence game.

 

Theft of Purchasing Power

Since the central bank’s balance sheet is largely composed of government debt, it has an incentive to manage the public’s “inflation expectations” and inflate the currency as inconspicuously as possible. This does of course not mean that the inflation racket is inhibited per se. The theft has merely been organized in such a manner that people don’t complain too much. The frog is boiled slowly, so to speak.

If the government had to actually raise taxes instead of borrowing the staggering sums of money it uses to keep its welfare/warfare programs running and keeping the vote buying mechanism well oiled, it would have to raise taxes by so much that it would face a rebellion. Instead government resorts to inflation. From the government’s perspective, money supply inflation is nothing but a cleverly disguised hidden tax.

 

gold_vs_currencies_ppp1900-2005

Fiat currencies in the 20th century – countless monetary catastrophes have been unfolding around the world at varying speed since the establishment of the Federal Reserve. It is worth noting that this chart is by now a bit dated and doesn’t yet include the large gain in gold’s purchasing power vs. fiat currencies since 2005 (image via the Gold Eagle editorial Fiat Money Systems).

In a missive published in 2007, veteran market analyst Richard Russell reminisced about the $125 his first job after college earned him per month and the then very high $22.50 he had to pay for his $10,000 GI life insurance policy per month. A new car cost $450 at the time. Those were princely sums in the 1940s, but have become chump change nowadays.

This devaluation has obviously not happened overnight, although it can happen very quickly if the public’s confidence in the money issuing authority crumbles. The public has become inured to the “inflation tax”, as it is proceeding at what appears to be a snail’s pace (at least according to the government’s official inflation measures). It is of course not possible to measure the “general level of prices”. There is an array of exchange ratios between money and countless disparate goods, the adding up of which simply makes no sense. Money itself is subject to the forces of supply and demand, just as the goods it is exchanged for are, leaving no fixed yardstick against which price changes can be measured. As a result, these inflation measures have to be taken with a big barrel of salt.

With legal tender legislation in place, fiat money has pushed gold out of circulation. No one is going to use sound money for transactions when he has the choice of using an unsound money instead. Over time, gold has increasingly moved from the world’s monetary bureaucracies into private hands, serving as a store of value and insurance against the failure of the modern fiat money experiment. Note though that the opposite will happen if an unsound money becomes entirely useless as a medium of exchange: In that event, people will adopt an alternative medium of exchange which they expect to hold its value better. E.g. during Zimbabwe’s hyperinflation, Zimbabweans began to use US dollars, South African rand and gold dust for payments.

On a global basis, only about 2.5% of all official central bank reserves are held in the form of gold these days. Some countries hold far larger percentages of their reserves in gold, most notably the US and many European countries, but even so, these reserves pale in comparison to the amount of fiat money and central bank credit they have issued.

 

Everybody is Happy

It is also important to note that although they are being subjected to a hidden tax, most citizens actually are quite happy with things as they are. As Gary North has observed in an essay, everybody involved appears to be happy, the robbers as well as the robbed. The banks are happy to be part of a cartel led by the central bank, which gives them immense latitude in indulging in consistent and flagrant overtrading of their capital, spurred on by the moral hazard created by having a “lender of last resort” backstopping them, which can conjure up money out of thin air without limit. Politicians and bureaucrats are happy because there is very little restriction on their spending and there is nothing stopping them from buying votes or indulging in whatever pet projects they happen to dream up.

And lastly, among the people who should actually rise in protest, there are large sub-groups that are either wards of the State and dependent on its largesse (the shameful secret of the welfare state is that it makes irresponsible slaves out of what would otherwise be free and responsible people), or have amassed so much debt in the pursuit of instant gratification that they are quite happy to see money being devalued at a steady pace. In a nation where the majority are debtors, inflation is the politically most palatable form of monetary policy. After all, everybody is focused on the short term (politicians and bureaucrats on their terms of office, consumers on their debt and their desire to buy more things they don’t need with money they don’t have, and so forth).

Few people stop to consider that this policy means ruin in the long run. Over time, the middle and lower classes will see their real incomes and living standards shrink ever more, while the true beneficiaries of inflation – those who get first dibs on newly created fiat money – amass more and more wealth in a kind of reverse redistribution from later receivers.

 

Wealth Producers Have No Say

Savers and genuine wealth producers are put at a great disadvantage by inflation. Wealth generators have to contend with the fact that the creation of additional money creates a demand for scarce goods without a preceding contribution to the pool of savings. Nothing can be exchanged for something, and their own savings will no longer allow them to exercise demand for goods to the extent they expected.

Not surprisingly, the small elite that actually profits from the fiat money system is quite content to take the long term view for itself. Actual producers of wealth are a very small group, too small to have a decisive voice in how things should be run. They would all have to go on strike if they wanted to exercise some pressure , a la John Galt. Unfortunately, big established businesses are usually in bed with the State and are happy with the status quo as welltheir main aim is to keep competition from upstarts at bay, so they are quite content with the various methods by which the market economy is hampered. They give lip service to the idea of truly free, competitive markets, but concurrently lobby for anti-competitive regulations all the time.

 

Decades of Successful Propaganda

The propaganda effort in support of the fiat money system has been enormous over the decades, and has been quite successful. Former Fed chairman Alan Greenspan once told Ron Paul on occasion of his semi-annual testimony in Congress that he believed “we have had extraordinary success in replicating the features of a gold standard“. We are quite sure he was aware that this is actually not the case. And yet, apart from Ron Paul, no Congressman would have even thought of questioning this absurd assertion. One would think that the fact that the US dollar – one of the world’s “better” fiat currencies – has lost 97% of its purchasing power since the Fed has been in business speaks for itself. Mises has already shown in 1920 that socialist central economic planning is literally impossible. No rational economy can be centrally planned. Central banking simply represents a special case of the theorem of the impossibility of socialism, applying to the financial sphere.

 

alchemist

Alan Greenspan unlocks the secret of making fiat money “as good as gold“.

There is still a market economy operating, hampered though it is, alongside the huge swathes of economic activity that have been appropriated by parasitic entities such as the State and its dependents. The part of the economy that can be considered relatively free produces all of our wealth. It unwittingly supports the fiat money system’s continued viability by doing what it does best, namely by enhancing productivity, and thereby exerting downward pressure on the prices of goods and services – which works against the upside pressure on prices created by monetary inflation.

 

Economic Interventionism vs. the Free Market

Apologists of the current system laud its “flexibility”. This is nothing more than an argument in favor of interventionism based on the misguided belief that the market economy is inherently prone to “failure”. Another commonly heard argument is: “If the economy is to grow, the supply of money must grow as well”, as if that were immediately obvious. In fact, many people believe this to be a truism, as it sounds superficially convincing. In reality, increasing the supply of money confers no benefit whatsoever on society at large. It is not important how much money one has in terms of numbers in a bank account, it is important what this money can buy. In a free market, the prices of goods and services will tend to steadily decline over time. That is the inevitable result of increasing productivity. This is why the widely accepted tenet that we “need constant inflation of the money supply to enable the economy to grow” is misguided.

It is not 100% certain that a truly free market economy would settle on using gold as money nowadays, although the chances seem good that it would play an important role. It seems highly probable that the previous historical period of trial and error that has led to the establishment of precious metals as money would still be widely regarded as likely to produce a satisfactory outcome. It is however not really important whether gold or something else would emerge as money. What is important is that the decision on what should be used as money would be arrived at voluntarily by the actions of market participants.

In an unhampered free market with a relatively stable supply of money, the supply of and demand for money would still be subject to fluctuations, but it is a good bet that these would be small. A freely arrived at market interest rate would at all times correctly signal to entrepreneurs what the state of society-wide time preferences was at any given point in time, allowing them to allocate capital in the most efficient manner.

By contrast, in a fiat money system in which interest rates are administered by a bureaucratic central economic planning agency the signals sent by interest rates to entrepreneurs about expected future consumer demand and the true cost of capital are continually falsified, and thereby encourage malinvestment of scarce capital. Phases during which the supply of credit and money expands strongly and malinvestments proliferate are known as “economic booms”, and everybody loves them. When a boom turns to bust and the liquidation of malinvested capital becomes necessary, few people are aware that the preceding boom is at fault. And so the cry for more monetary and fiscal intervention arises, which lengthens and deepens the malaise by putting malinvested capital on artificial life support.

Government mandated fiat currency simply does not work in the long run. We have empirical evidence galore – every fiat currency system in history has failed, except the current one, which has not failed yet. The modern fiat money system is more ingeniously designed than its historical predecessors and has a far greater amount of accumulated real wealth to draw sustenance from, so it seems likely that it will be relatively long-lived as far as fiat money systems go.

 

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Ben Bernanke indicating how long the current fiat money system will last.

 

In a truly free market, fiat money would never come into existence though. Greenspan was wrong – government bureaucrats cannot create something “as good as gold” by decree.

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shiftless's picture

It works until it doesn't

Self-enslavement's picture
Self-enslavement (not verified) shiftless Feb 21, 2015 7:07 PM

Paper money works fine as long as freshly printed currency is re-injected back into the very bottom of the economic pyramid, but the moment that changes it starts to create disparity in wealth.

Self-enslavement's picture
Self-enslavement (not verified) Self-enslavement Feb 21, 2015 7:20 PM

Metal works fine as a currency as long as all taxes collected are re-injected back into the very bottom of the economic pyramid, otherwise a wealth disparity is created.

Self-enslavement's picture
Self-enslavement (not verified) Self-enslavement Feb 21, 2015 7:25 PM

Problem is when you let the selfishites gain control of an economic system. All the wealth circulates at the top of the economic pyramid, loans to the bottom with interest create a vacuum on the economy and suck the wealth out of it for the benefit of the rich.

Self-enslavement's picture
Self-enslavement (not verified) Self-enslavement Feb 21, 2015 7:26 PM

Selfishites could fuck up a wet dream.

Publicus's picture

Because wage slavery works very well to keep the little people in line.

 

We'll just print money to fund jobs.

Vampyroteuthis infernalis's picture

Sorry to break it to you. All societies fail, thus, all currencies will fail eventually too. Backed by gold or not.

Unknown User's picture

This article makes an idiotic assumption that “papyrus” commodity is a bad medium of exchange to subsequently conclude that gold commodity is good money. To do that, the article skipped over 700 years during which Roman Republic conquered the World using cupper and bronze coins, only to collapse when emperors took over and introduced gold coins.  Then it describes how Tally Sticks were destroyed after they were successfully used for hundreds of years.

The problem with money is who issues it and regulate value.  To make a long story short, ideal money should represent standardized units of arbitrary work, i.e., units of value.  This is why such money is known as value-based money (note that we are now using debt-based money).  This type of money is created by a government whenever new value is created.  This is similar to a corporation issuing new shares to represent new value added to the business, for example, a new factory.  Just as shares of a corporation represent part ownership of the corporation, value-based money represents part ownership of the country. 

The Secret of Oz


 

Bendromeda Strain's picture

Here is a tally stick, you can take a hike with it, or you can alleviate your obvious constipation with it. Should you choose hike, take Denninger and Still with you.

One Dollar of Capital and every other rule based system relies on the incorruptability of those entrusted - FAIL

Only a system where debts are self extinguished and counterparty risk mitigated can be considered honest. By the way, Secret of Oz should have come with a fiat back guarantee. It started out good but collapsed in a pile of guano by the end.

kaiserhoff's picture

I've asked many a class this question:  why is money, money?

Look in the upper left hand corner.  "this note is legal tender, for all debts, public and private."

Without debt, fiat has some convenience factors, but nothing else.

Enough said.

Self-enslavement's picture
Self-enslavement (not verified) kaiserhoff Feb 21, 2015 7:28 PM

You selfishites lie. Paper money is created as credit and can be given freely.

Self-enslavement's picture
Self-enslavement (not verified) Self-enslavement Feb 21, 2015 7:30 PM

Your paper may as well read: "only selfishites can print money, otherwise we will all have to get jobs and that would be a holocaust"

Usurious's picture
Usurious (not verified) kaiserhoff Feb 21, 2015 7:32 PM

 

 

$200 trillion debt in the world thanks to debt-based fiat.......

how about 'debt free money' and or 'interest free credit'.......

 

Augustus's picture

A government with the power to tax makes everyone a debtor to the government.

That government then deternes the "currency" with which those tax debts can be paid.

If there is a normal tax on income of 30%, the mandated currency for tax debt payment will predominate and drive out other stores of value.

will ling's picture
will ling (not verified) shiftless Feb 21, 2015 8:08 PM

ala circa 400 A.D. til 1200 A.D.

buzzsaw99's picture

the value of gold is subject to the whims of sentiment every bit as much as digital dollars. someday people may consider gold to be not worth much at all.

Theta_Burn's picture

Its the transition between CB loosing control and that someday you pointed out, gold will be the bees knees.. after that, a can of soup or a bottle of whiskey will get you safe passage to the next check-point..

A memory stick with digital currency offering would probably get you shot...

 

buzzsaw99's picture

gasoline, water, or natural gas produced from pig shit will be worth more than gold someday. gold is a tool of the same central bankers that everyone here hates. i find that funny.

Theta_Burn's picture

Gold is the bane of the CB's

You should find their manipulation of it, as it suits their needs, tragic

Bendromeda Strain's picture

Whoever hit him with the ugly stick blinded him as well...

The value of gold may change by agreement (it takes two to transact) but the nature of gold doesn't. Honest weights and measures has always been the standard of a just society. Goes back to the Pentateuch (uh oh, I went there).

Bilderberg Member's picture

Only one person in the world thought the Los Angeles Clippers were worth paying 2 billion dollars for...Guess how much that makes the LA Clippers "worth"?

graspAU's picture

It may be the tool for control under today's circumstances, but it is also what mankind has settled on as money for thousands of years and its supply is from collapsing stars of a certain size, or colliding neutron stars instead of the Bernanke typing in an amount to mark up the accounts of the banks.

"Fiat money is the child of the arrogance of human intellect, which has sought to invalidate the laws of human nature which have regarded the precious metals as money for thousands of years, and sought to substitute an intellectual construct for the real thing. Now we are going to pay for that arrogance." -Hugo Salinas Price

"...More significantly, no fiat currency has ever suffered the abuse that has been inflicted upon the United States dollar, meaning that it is at extreme risk. Gold has been money for 5,000 years. It has not merely survived, it has prevailed over each and every fiat currency collapse throughout history..." -

-Stewart Dougherty  - Specialist in inferential analysis, the practice of identifying historic and contemporary patterns and then extrapolating their likely effects upon the future. Dougherty was educated at Tufts University (B.A., magna cum laude), and Harvard Business School (M.B.A. and academic Fellow) – March 2010

“The relative average abundance (of gold) in our Solar System appears higher than can be made in the early universe, in stars, and even in typical supernova explosions. Some astronomers have recently suggested that neutron-rich heavy elements such as gold might be most easily made in rare neutron-rich explosions such as the collision of neutron stars."

http://apod.nasa.gov/apod/ap080518.html

 “Only in a supernova is it possible to create atoms with 30 protons, 40 protons, 50 protons or even 60 protons. Nature prefers even numbers for stability, but every so often, the star will forge an odd-numbered atom, a real rarity: gold! Gold is a rare, odd-numbered atom with 79 protons. For every single gold atom in the universe, there are 1 million iron atoms..."

-http://www.npr.org/templates/story/story.php?storyId=7397200

 

 

toys for tits's picture

Do you have any evidence that gold became worthless in the last few thousand years of history?

All past fiats have become worthless.

I remember in the early 80's when 60 Minutes did a show on Brazil and the massive inflation there.  What you could buy a car for would only get a beer less than two years later.  I can't imagine living in that kind of society.

Theta_Burn's picture

Gold or paper

Hmm..

Gold can be redeemed anywhere for "paper"

When anyone says "its good as gold" why not insist on gold then?

 

 

andrewp111's picture

Physical Gold cannot be transferred over digital communications systems. Digits can. The convenience value is too high. Even today, I rarely see anyone in a restaurant paying with cash. >90% of the public uses credit cards for everything. That is why fiat currency isn't going away. There might be future changes in the issuer and how it is managed and transacted, but fiat is here to stay.

Dre4dwolf's picture

Convert gold to fiat -> fiat to bitcoins ->You go to destination of your choice->bitcoins to gold/fiat depending on what the gold dealer likes to take... you will o/c pay a transfer fee. . . but better than getting your wealth confiscated by the TSA goons.

You cant take large quantities of cash on a plane, just like large quantities of gold will be questioned. . . but not for nothing you could wear a million dollars worth of gold/diamond jewelry and get on a plane . . . no one would really bug you so long as you claim it...

 

Every currency/asset class has its pros and cons nothing is guaranteed to appreciate.

Stocks could go down any moment.

Realestate could go down any moment.

Dollars could be worthless tomorrow.

Gold/Silver could go bust tomorrow.

 

So what are you supposed to gamble on?

The answer would be . . . for everyone to stop gambling and hoarding, and to just buy/use what you need . . .  then you would have what we call... efficient markets with assets... priced to market instead of priced to speculation buying panic frenzies.

 

Bendromeda Strain's picture

Physical Gold cannot be transferred over digital communications systems. Digits can. The convenience value is too high. Even today, I rarely see anyone in a restaurant paying with cash. >90% of the public uses credit cards for everything. That is why fiat currency isn't going away. There might be future changes in the issuer and how it is managed and transacted, but fiat is here to stay.

Yes - convenience and laziness go hand in hand to create a most useful trap. Freegold is said to take this phenomenon into account.

gwar5's picture

Trapped like rats. Rothschilds built a better mouse trap. 

Joebloinvestor's picture

It is easier to convince someone they have something of value then to prove it.

 

Goatboy's picture

Fiat money in itself is functional and brilliant. It mimics blood levels/circulation within organism. Regulatory body is able to put out just enough as it is needed, in a healthy organism/society.

Problem is not in fiat but in other spheres like cultural values, habits and corruption. Gold as currency is deflationary, destructive and growth inhibiting.

Theta_Burn's picture

You forgot to add that gold is honest, and  unmanipulable....

Goatboy's picture

I do not agree. Gold's "honesty" is foolish because it never disappears. And everything in this reality does, first and foremost life necessities like food. Gold, as long as widely accepted, allows unnatural accumulation of "wealth" that doesn't reflect any natural process to which we are tied. Its inherently pathological as "store of value". That unnatural accumulation comes from its very nature while fiat super-concentration happens deliberately through corrupted politics/values/dynasties.

doc333's picture

Dude, you're so mixed up it's hard to know where to start. I'll keep it simple for you - GOLD has INTRNSIC value (you couldn't pontificate on your computer or use your cell phone without it, among many other things). Fiat can always be used for ass wiping or fire starting, but it's intrinsic value is close to zip. There, fixed it for you.

Anusocracy's picture

@Goatboy

Bullshit analogy. An organism tightly regulates the quantity and quality of its blood and has a distinct limit to its growth.

Fiat money is more like cancer in an organism. Unwarranted unneeded growth destroying the organism's viability with death as the consequence.

pgroup's picture

In that case, can I have your gold? You don't have any?

Then I'm richer than you. :)

will ling's picture
will ling (not verified) Feb 21, 2015 7:06 PM

answer is FEAR - but w/diminishing returns. ends horrifically.

rickv404's picture

It works only as long as your economy is viable to endure the undercutting of productivity with the increase in currency. It can't endure indefinitely with more and more, for the sake of governments doling out more and more handouts. You are progressively impoverishing people.

cynicalskeptic's picture

 

ANY form of money works ONLY if it exists in proportion to the total value of economic activity in a given economy.  

In the past the LACK of 'money' - specie in gold or silver - has hindered economic activity and growth.  This was a real problem in the 13 colonies - the gold and silver earned in the colonies immediately was 'spent' and left the colonies to pay for imported manufactured goods from England.  Commerce in the colonies and between the colonies suffered because there was not enough money (specie) to facilitate trade.  Even in the early days of the US Republic gold and silver were often in short supply so that even without a 'national Bank' the country ended up with state chartered 'banks' issuing banknotes (promises to pay specie) that were often unbacked and frequwently counterfeited.  The real irony is that counterfeit notes on 'good' banks were oftenn more readily accepted than legitimate notes coming from 'bad' banks.  You had large printed guides to banknotes - with notes trading at a discount the further you got geographically from the issuing bank.  It was a truly half assed system.  The shortage of money often led to farmers losing theor farms for unpaid taxes - they lacked the specie to pay taxes even though their crops were worth far more than what they owed.  The whiskey rebellion was in part due to whiskey being a compact storage of 'value' - a way to convert surplus crops into a readily exchanged medium.

IF - and that rarely happens - the money in circulation in an economy expands (AND contracts) in proportion to the level of economic activity you will have prosperity.  Pennsylvania had a tightly controlled currency when a colony and their fiat experiment worked quite well.  Yet Rhode Island issued its own notes without limit - and suffered from rampant inflation.   The difference in prosperoty crossing from Rhode Island to Massachussets was quite clear and visible.

But there are a  number of problems - foremost among them is that economies are NOT 'closed'.  One nation run prudently can still be subject to the ill effects on other nations.  The US - with the current world reserve currency - has forced others to use its increasingly devalued currency and used that position of power to buy up tangible assets throughout the world on the cheap.   Great Britain - seeing its silver flow to China in payment for tea, porcelain and silk FORCED China to allow Opium imports (in two wars) as a way to recoup their trade losses.   Might is often used to overcome economic stupidity.

As soon as ANY government realizes they can spend by issuing DEBT and NOT taxing their populace in a 'pay as spent' manner, they are ont he path to eventyual default and destruction.  Inflation is inevietable with the government growing increasingly desperate to perpetuate a failing model.

One of the limits on US willingness to go to war was ECONOMIC.  In the War of 1812, the national government of the US was limited by its ability to fund the Army and Navy.  Only by issuing 'unbacked fiat - greenbacks - was the North able to fund the Civil War.   Past practice in Europe was for governments to BORROW funds for major wars when taxing capabilites had been exhausted (often hoping to repay debt via war spoils).  The US relied on war bonds in WWII but was nearing the limit of its ability to borrow from its population in 1945. 

Sadly - IMO - you will never see responsible leaders willing to take the hard and difficult path of limiting spending to national income and as long as they can roll over debt, they will do so - irrespective of the ultimate consequences.  Our Founding Fathers saw this and attempted to limit the power of government in limiting taxing powere and limiting government to coining silver and gold - specifically FORBIDING fiat currency.  But their successors found the prospecto funlimited spending far too attractive to ignore.

 

 

Clesthenes's picture

“Why do fiat currencies work?”

“Fiat” money works because a vast majority of men desire to ‘visit sins of the fathers upon their children to the third and fourth generation’.

 

Men have even built a religion on this basis.  At the time its basic legends and fairy tales were written, men had to do this with real money (gold and silver); and cannibalizing three or four generations were thot to be the limit.  Since then, the miracle of central banking has extended this almost without limit.  With central banking, government debt has been “monetized” to such an amount that there is now enough such debt on the books to financially cannibalize following generations of Americans to the end of time.  You don’t have to take my word for it: this result is derived from data, assumptions and formulas provided by the federal government.

Self-enslavement's picture
Self-enslavement (not verified) Clesthenes Feb 21, 2015 7:34 PM

It works because our property taxes are not collected in tomatoes or chickens. We have to get the paper away from them in order to pay taxes to them. Also we have to pay interest for eternity to them so they can keep us as their slaves.

Oldwood's picture

Because a lie is ALWAYS preferable to the truth? We accept change because we are always promised it will be better, to our greater advantage...really. Exactly the same way they will eventually eliminate currency and we will all be wearing chips that make our life so much more easy. Everything that corrupts and weakens us is a convenience.

The promise of more with less effort.

Something for nothing.

Care to place a bet?

Its easy, and everyone is a winner.

homiegot's picture

Money is 100% psychological. It's a construct we all seem to trust because of its convenience.

Goatboy's picture

..as long as we do :D

Well said.

Joebloinvestor's picture

Ask anyone in skinny jeans if they would give up their fiat in a wallet for an bio/id scan linked charge account.

Convenience rules.

dbTX's picture

Great article / history lesson, thanks.

diana_in_spain's picture

what monetary system are the BRICS using?

I Write Code's picture

You can't wipe your butt with bitcoins.

Dre4dwolf's picture

The answer is DEBT.

IF you get the entire population in DEBT then they have to work to earn FIAT to PAY THE DEBTS to KEEP THE SHIT THEY CANT AFFORD.

 

In order for FIAT to work, the people using it must be debt slaves.

 

Federal Reserve notes = Debt Slavery

Gold = Free People with assets that are not encumbered.

To expand on this . . .some food for thought:

The confusion stems from a lack of understanding of whats going on, ill give you a few examples.

When you go to a resteraunt, and you sit down and eat your dinner, you usually don't pay up-front.... you sit down eat . . . and then ask for THE CHECK, why aren't you asking for a BILL?

Because the assumption in our society is that . . .  no one has any money (gold or silver) and that the DEBT will be payed with another DEBT, so the resteraunt issues a CHECK (pays you with the CHECK) (this creates a LOAN) which you OFFSET with CREDITS (Federal Reserve Notes or Credit Cards or Bank Transfer (debit), so you are paying a LOAN off with a DEBT instrument (Federal Reserve Notes/Bank Notes / Checks/Credit Cards etc... are all DEBT NOTES)

Same thing applies with your phone bill, you don't really get a BILL you get a STATEMENT OF ACCOUNT that Comes with an ATTACHED REMITANCE (again a CHECK just like the resteraunt) you CONSUMED the phone usage and the Phone Company Sent you a CHECK (Remitance) (a Loan)... these are fungible financial instruments the Phone company is quite literrally sending you the remitance (check) with which to pay the phone bill with.... and you attach a Cheque or pay online using another debt instrument . . .

 

No one PAYS for anything in a FIAT DEBT BASED SYSTEM, because NO ONE HAS LEGAL MONEY (gold and silver) so we settle STATEMENTS OF ACCOUNT with Debt Instruments/Credit.

There are no DEBITS AND CREDITS for the most part, its just Credits being transfered from one to the other. . . whoever has the most credits is owed the most credits by others.

This is why Federal Reserve notes have counter party risk. . . 

Also the act of swiping a credit card/taking a car loan out/taking a home loan CREATES currency (credit) out of thin air, the car company does not have 25,000USD to LOAN you to buy its car, but it LOANS it into creation (deposits the value of the car in its own accounts) and then you are on the hook to off-set those credits (delete them from circulation) by paying the car off. (You create a promissory note (currency note like a FRN but from you) the car company records that on its books as if you gave them an ASSET worth 25k) so at that point, your car loan is paid in full (from the accounting standpoint) you gave them 25k worth of debt insrument and they gave you car worth 25k worth of debt notes (accounts are balanced)... then you pay the car company 25k ontop plus interest (profit)... when you pay the 25k back the car company LEGALLY should return the debt instrument (signed promissory note) back to you... in-fact you should demand they do so that it can't be used again . . . 

Its a backwards system... the borrower is the creator of the currency ( through demand ) its a Demand Based Debt Exchange System.

Check your monthly statements/bills it will probably say "Remittance" on it.

Blacks Law Dictionary :

Remittance - "A sum of money sent to another as payment for goods or services. 2 An instrument (such as a check) used for sending money. 3 The action or process of sending money to another person or place"

^^ Your monthly statements are actually Negotiable Instruments by the legal definition.

 

And on another note, this is all illegal ^ its not constitutional, but this is how the world operates  . . . every time you spend a FRN/Swipe a credit card you are pretty much violating the constitution and you should feel terrible about it.

Anusocracy's picture

From goods and services paid for with goods and services to goods and services paid for with future goods and services.

Sounds like a high time preference low IQ civilization to me.